Proceeds from a life settlement are taxed in three tiers — return of basis tax-free, the amount between basis and cash surrender value as ordinary income, and everything above cash surrender value as long-term capital gain — unless the insured qualifies under IRC Sec. 101(g), in which case the proceeds may be excluded from income entirely. That single paragraph is the reason a CPA is often the right professional to raise this, and the reason getting it wrong is expensive.
You are also frequently the first professional to see the problem, because a recurring premium shows up on a cash-flow review, on a Schedule of a closely held entity, or on a trust’s Form 1041 long before anyone mentions it to the attorney. A client paying $14,000 a year for coverage nobody needs is a line item you can see and the family cannot.
Send us a redacted policy cover page. With the client’s permission, one page starts a free review. Initial read is typically one to two business days, with no obligation for you or the client. Call (305) 209-7183.
In This Article
The Three-Tier Framework, Applied
Start with basis. For a life insurance contract, basis is generally aggregate premiums paid, reduced by amounts previously received tax-free such as dividends and withdrawals. Proceeds up to that figure are a recovery of capital and are not taxed. The amount from basis up to cash surrender value is ordinary income — the inside build-up that would have been taxed on surrender. Anything above cash surrender value is capital gain, long-term where the policy was held more than a year, which it almost always was.
The practical consequence is that the ordinary-income slice is capped by cash surrender value regardless of how large the settlement is. On a guaranteed universal life policy with little or no cash value, nearly the entire gain above basis lands in the capital gain tier. That distinction is worth modeling before the client signs anything.
Post-TCJA Basis: Stop Reducing for Cost of Insurance
Before 2017, Rev. Rul. 2009-13 required a seller to reduce basis by the cost of insurance charges when computing gain on a sale, producing a larger taxable gain on a sale than on a surrender of the same policy. The Tax Cuts and Jobs Act eliminated that adjustment for transactions after August 25, 2017, and the IRS reflected the change in Rev. Rul. 2020-05, which restates the earlier guidance under current law.
If your firm’s checklist or workpaper template still carries the cost-of-insurance reduction, it is producing the wrong number. That is the single most common technical error in this area.
IRC Sec. 101(g) and the Terminal or Chronic Illness Exclusion
Where the insured is terminally ill — generally certified by a physician as reasonably expected to die within 24 months — amounts received from a viatical settlement provider are treated as death benefits and excluded from gross income under IRC Sec. 101(g). Chronically ill insureds may also qualify, subject to per-diem limitations and the requirement that proceeds be used for qualified long-term care services not otherwise compensated.
Two conditions get missed. The certification has to exist and be documented contemporaneously, not reconstructed after the fact. And the counterparty generally needs to meet the statutory definition of a viatical settlement provider, which in Tennessee means licensure under the state’s viatical settlement provisions at Tenn. Code Ann. Title 56, Chapter 50, administered by the Tennessee Department of Commerce and Insurance. Verify both before you take the exclusion position on a return.
| Tier | Amount | Federal character | Authority / note |
|---|---|---|---|
| 1 | Up to adjusted basis (premiums paid, less tax-free distributions) | Not taxable — return of capital | No COI reduction post-TCJA; Rev. Rul. 2020-05 |
| 2 | Basis up to cash surrender value | Ordinary income | Same inside build-up taxed on a surrender |
| 3 | Above cash surrender value | Long-term capital gain (held >1 year) | Larger tier where CSV is low, as with GUL |
| Exclusion | Entire proceeds | Excluded from gross income | IRC Sec. 101(g); terminal certification generally 24 months or less |
| State | All tiers | No Tennessee individual income tax | Hall income tax repealed for tax years beginning 1/1/2021 |
Transfer-for-Value and Entity-Owned Policies
Where a policy changed hands before the settlement — a buy-sell restructuring, a transfer out of an entity, an intra-family transfer for consideration — IRC Sec. 101(a)(2) can convert an otherwise excludable death benefit into taxable income for the buyer, subject to the statutory exceptions. The 2017 reporting rules added Forms 1099-LS and 1099-SB and the reportable policy sale definition, which pulled a lot of transactions into the reporting regime that previously flew under it.
For your engagement, the practical items are: confirm the ownership history before the sale, expect a Form 1099-LS from the acquirer and a Form 1099-SB from the issuer reporting the seller’s investment in the contract, and reconcile the carrier’s reported basis figure against your own computation. Carrier-reported basis is frequently not what the return should use.
Where You Will Spot the Case
Four places, reliably. A retirement cash-flow projection with a permanent life premium the client cannot articulate a reason for. A closely held entity still expensing key-person coverage on a shareholder who exited. A Form 1041 for an irrevocable life insurance trust where the only activity all year is a premium payment. And a long-term care planning conversation where the family is about to surrender a policy to get under an asset limit.
In each case the question is the same and takes one sentence: does anyone still need this death benefit, and has anyone established what the policy is worth to a third party?
The Tennessee Overlay
State-level tax analysis in Tennessee is unusually short. Tennessee imposes no individual income tax on wages or ordinary income, and the Hall income tax on interest and dividends was fully repealed effective for tax years beginning January 1, 2021. For an individual client the settlement analysis is therefore essentially federal, though entity-level franchise and excise tax questions for a closely held seller should be confirmed with the Tennessee Department of Revenue.
On the benefits side, long-term care Medicaid in Tennessee runs through TennCare CHOICES with a $2,000 individual countable-asset limit as of 2026 (confirm current figures). Cash surrender value above the small-face-value disregard is a countable resource, so a client facing an eligibility problem has to deal with the policy regardless — the only question is whether they get surrender value or a market price for it. Our Tennessee life settlement tax overview collects the details.
How a Referral Works
With the client’s permission, send only the policy cover page. It identifies carrier, product type, face amount, and issue date — enough for a preliminary read. No fee, no engagement, no obligation on either side.
Initial read is typically one to two business days. An indicative range needs three more documents: a current in-force illustration, the latest carrier statement, and a signed HIPAA authorization. A standard file from there through funding runs roughly 60 to 120 days.
The client stays in control the entire time and can stop at any point before closing. You keep the tax analysis where it belongs — with you. Call (305) 209-7183 or send the cover page for a free review.
This page is educational only and is not tax, legal, or investment advice. Pine Lake Life Solutions does not provide tax counsel; the client’s own CPA and attorney should review any transaction before it is executed.
Frequently Asked Questions
Do I still reduce basis by the cost of insurance on a sale?
No. The Tax Cuts and Jobs Act eliminated that adjustment for transactions after August 25, 2017, and Rev. Rul. 2020-05 restates the prior guidance under current law. Basis is generally aggregate premiums paid less amounts previously received tax-free. Firm checklists written before 2018 frequently still carry the old reduction.
What forms should I expect to see?
Generally a Form 1099-LS from the acquirer reporting the reportable policy sale and a Form 1099-SB from the issuer reporting the seller’s investment in the contract. Reconcile the carrier-reported basis against your own computation, because the two often differ.
When do proceeds qualify for exclusion under IRC Sec. 101(g)?
Generally where the insured is certified by a physician as terminally ill with a life expectancy of 24 months or less, with the proceeds paid by a qualifying viatical settlement provider. Chronically ill insureds may also qualify subject to per-diem limits and the qualified long-term care services requirement. Documentation must be contemporaneous.
Does Tennessee tax the gain at the state level?
Tennessee has no individual income tax on wages or ordinary income, and the Hall income tax on interest and dividends was fully repealed for tax years beginning January 1, 2021. Entity-level franchise and excise questions for a closely held seller should be confirmed with the Tennessee Department of Revenue.
How does transfer-for-value affect the analysis?
IRC Sec. 101(a)(2) can limit the exclusion of a death benefit where a policy was transferred for valuable consideration, subject to the statutory exceptions. Review the full ownership history before the sale, particularly for buy-sell restructurings and transfers out of entities.
Do proceeds affect TennCare eligibility?
Yes, as a resource once received. Cash surrender value is already countable above the small-face-value disregard, so a client facing eligibility has to address the policy either way. TennCare CHOICES uses a $2,000 individual countable-asset limit as of 2026; confirm current figures before advising.
Is a settlement always better than a surrender on an after-tax basis?
Not always, and modeling it is exactly the CPA’s job. The ordinary-income tier is capped at cash surrender value, so a low-cash-value policy pushes most of the gain into capital gain treatment, while a heavily funded whole life policy can look different. Run both scenarios before the client decides.
What is the timeline from referral to funds?
An initial read on a cover page typically comes back in one to two business days. From full submission through funding a standard file runs roughly 60 to 120 days, so plan the tax-year impact accordingly if a year-end boundary is close.
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Related Reading
- Life Settlement Taxes Tennessee
- Cash Surrender Value Life Insurance
- Life Settlement Vs Surrender
- Tennessee Medicaid Asset Income Limits
- Education Center
Pine Lake Life Solutions does not purchase life insurance policies and does not provide legal, tax, or investment advice. Information provided is for educational purposes only. Eligibility for any option, including life settlements, is not guaranteed and depends on individual circumstances, policy terms, underwriting, and market conditions. Consult independent legal, tax, or financial professionals before making decisions regarding a life insurance policy.